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The advantages of a common currency Reduced transaction costs Elimination of currency risk Greater transparency and possibly greater competition because prices are easier to compare.

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The disadvantages of a single currency A currency area is limited to a one-size-fits-all monetary policy loss of a mechanism for adjustment changes in relative prices and wages are much more easily made via currency depreciation than by renegotiating individual contracts. (Iceland v.s. Spain) When there are “asymmetric shocks”, such adjustments are necessary. Imagine that a vast housing boom leads to full employment and rising wages in part, but only part, of a currency area, then goes bust.

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Optimum Currency Area Theory Optimum currency area theory is about weighing the balance between those advantages and those potential costs. This “weighing” takes place only in a qualitative sense Looking at factors that might mitigate the costs arising from the loss of monetary flexibility.

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Labor Mobility Mundell (1961) argued that a single currency was more likely to be workable if the regions sharing that currency were characterized by high mutual labor mobility. Suppose that the state of Massachusetts takes a major asymmetric hit to its economy that sharply reduces employment If without labor mobility, the only way to restore full employment is to regain the lost jobs, which will require a large fall in relative wages to make the state more competitive. But if there is high labor mobility, full employment can instead be restored through emigration. (Table 1)

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Fiscal Integration Peter Kenen’s argument that fiscal integration can help a lot in dealing with asymmetric shocks. If Florida suffers an asymmetric adverse shock, it will receive an automatic compensating transfer from the rest of the country. (Table 2) Florida banks benefit from federal deposit insurance Federal government does not face a borrowing constraint, but it would be a real problem if Florida were a sovereign state

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With limited labor mobility and no fiscal integration. Why did European Leaders believe Euro would work ? The belief that two factors would make the adjustment problems manageable. Adopt sound fiscal policies, and thereby reduce the incidence of asymmetric shocks Second, countries would engage in structural reforms that would make labor markets – and, presumably, wages – flexible enough

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The euro crisis Many investors believed that the big risks associated with cross-border investment within Europe had been eliminated. After the creation of the euro, there was massive capital movement from Europe’s core to its periphery leading to an economic boom in the periphery and significantly higher inflation rates in Spain, Greece, etc. than in Germany. When private capital flows from the core to the periphery came to a sudden stop, suddenly the euro faced a major adjustment problem. “Internal devaluation” – restoring competitiveness through wage cuts as– has proved extremely hard. (Table 3)

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Making the euro workable 1. Europe-wide backing of banks 2. The ECB as a lender of last resort to governments 3. A higher inflation target. Euro experience suggests that downward nominal wage rigidity is a big issue. The burden of adjustment might be substantially less if the overall Eurozone inflation rate were higher. Spain and other peripheral nations could restore competitiveness simply by lagging inflation in the core countries.